Italy whose-debt-to-GDP ratio is second only to Greece in the euro zone at 120 percent, was among a raft of European countries hit by a mass downgrade from Standard & Poor’s on Friday, with its sovereign rating cut by two notches to BBB+. MSNBC conducted a poll amoungst Italians regarding the Euro and found that

Fifty-five percent of Italians have lost confidence in the euro single currency and nearly a third think it would be better to return to the lira, an opinion poll showed on Monday.

Well, I don’t know whats its like in Italy, but in Ireland when it was introduced, people immediately noticed prices increase dramatically. From day one traders took advantage in the confusion and hiked up prices. Since then we cheap interest rates, the country went on a credit binge. With no power of the Irish Central Bank to control rates, the country lived on cheap credit which caused a massive bubble. Hence the trouble the country is in now.

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Since Mario Draghi (ex Goldman Sachs) came to power as head of ECB, we have seen policies put in place to ensure euro zone bonds are an attractive to buy. Interest rates were first dropped and then the LTRO was introduced, i.e borrow cheap at 1% over 3 years with the intention of purchasing sovereign debt (just as Nicholas Sarkozy). Well you can see from the chart below, the ECB may not be printing yeah right, but has massively expanded its balance sheet.

Where are the Germans in all this? After all they are totally against printing money, yet they benefit from the fall of the euro since their exports become much cheaper.

The ECB’s total assets have risen by 38% from €1.94trn on 1st July to €2.69trn on 6 jan 2012, while the fed’s total assets rose by 1%. And you know what this means for gold.

More importantly to fans of sound currency, the bottom line is that between the ECB (assuming it does proceed with a €1 trillion LTRO), and the Fed (assuming it does go ahead and launch a $600 billion minimum (and as much as $1 trillion) QE3 as every bank expects by June), the global balance sheet will have increased by nearly $3 trillion since July, even as gold has actually declined in price. And if anyone needs the final clue as to what is going on, an increase in the US debt ceiling to $16.4 trillion which is expected to pass imminently, would mean that by simple correlation a fair value for the yellow metal would be just under $2000 per ounce.

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The horse trading continues. Greece needs to agree the details of its second bailout and how much private holders are going to take a hit on their bonds before €14.5bn worth of bonds mature on March 20. The reason this is important is, if there is an agreement then no credit default swaps are triggered. US banks are exposed to Greece debt through these credit default swaps.

Three aspects of a PSI agreement appear to have been struck. Private sector holders will be asked to voluntarily forgive half of the Greece’s debt that it holds (~200 bln euros). Of the 50% they will get back 15% is likely to be in cash, to be paid out of the second aid package. Greece and the banks also appear to have agreed in that in principle the PSI should be governed by UK law rather than Greek law.

For the other 35%, private sector will be given a new bond. Here is where the challenge really begins. What should the coupon be on the new bond ? The Greek government and the IMF, of course, are seeking a low coupon, with some suggestion (IMF/Germany) as low as 2%, while the group representing the banks wants a 4%+ coupon.

Greece with the help of the IMF in negotiations are looking at a 75% cut

Ultimately what is at stake is the real losses taken by the private sector and this is a function of net present value. Greece and the IMF appear to be pushing for as much as a 75% loss on NPV basis, while the banks, many of whom have written down 50% of their Greek holdings, appear willing to accept a 60-65% hit on the NPV basis.

As well as the haircut, Greece is negotiating the length of maturity of the bonds

There also seems to be some disagreement on the maturity of the new bond, with the IMF and Greece seeking 30 year, while the banks are willing to accept 20-year duration.

Who is going to lose out the most?

If collective action clauses are retroactively introduced, they would seem to apply to ECB holdings as well. It is not clear how much Greek bonds the ECB owns. Estimates ranges from around 40 bln euros to 70 bln. Regardless of the particulars, the ECB is thought to be the single largest owner of Greek bonds, which it acquired at deep discounts (estimates range between 20 and 30%).

This underscores the difficult dilemma the ECB finds itself. Participating in the haircut damages the ECB. It is possible that the loss, even from the discounted levels it purchased the Greek bonds, would wipe out the ECB’s capital. Alternatively, as we have point out previously, if the ECB does not take a haircut, it undermines the effectiveness of its sovereign bond purchases.